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Viewpoints: Is now the time to long Hong Kong shares?
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Viewpoints: Is now the time to long Hong Kong shares?
In October 2022, the Hang Seng Index reached its lowest level since 2009. However, as the market traded on the optimism surrounding China's re-opening and economic recovery, both the Hang Seng and China's onshore stocks experienced a significant rebound. The Hang Seng rebounded by nearly 20% from its October 2022 low during the opening of 2023. Unfortunately, the bull market was short-lived as China's recovery fell below expectations and the US Federal Reserve continued to hike interest rates.
Since turning bearish in February, the Hang Seng index has continued to lose value in the first half of 2023. Hang Seng is trading at a depressed level compared to global markets, with the Nikkei and S&P 500 gaining 24% and 15% respectively year-to-date in 2023. The broader emerging market has also outperformed, with the MSCI Emerging Markets excluding China ETF (EMXC) gaining 9%. In contrast, the Hang Seng Index has lost 7% since the beginning of 2023, underperforming all major indices, including the China onshore market.
As of writing, only 22 out of the 80 constituents in the Hang Seng Index have gained in 2023. Under geopolitical tensions and the expectation of industrial activity recovery, many top gainers are concentrated in the energy sector.
With Hang Seng's plummeting valuation, many are wondering whether it is an attractive low point to consider buying.
In today's post, we have curated key aspects to consider by highlighting viewpoints from analysts and economists on the future of Hong Kong shares and the Chinese economy for the second half of 2023.
Viewpoints: How to understand the valuation of Hong Kong equities and why they entered a bear market
To better understand the current situation of Hong Kong equities, it is important to first understand the key factors that influence the valuation. An article from "沧海一土狗" on WeChat, a blog widely read by financial analysts and investors in China, provides a concise and comprehensive framework for understanding these key factors and their impact on Hong Kong stocks.
Below are redacted translations of the main takeaways from the article:
In hindsight, there are two reasons why Hong Kong stocks have suffered [in 2022]:
1. On the asset side, China's economic prospects are not good. Since November 2020, China's PMI has been declining and the situation in 2022 is worse than in 2021. It is even difficult for PMI to remain above 50 which is the dividing line between boom and bust.
2. On the liability side, the US is hiking interest rates. The two-year US Treasury yield did not start to rise until June 2021. Since then, it has increased and exceeded 4.7% at its peak.
The decline in the Chinese economy and the interest rate hikes in the US are two major global trends that are burdening Hong Kong stocks, causing them to fall further.
In addition, there is an “invisible” reason, which is the impact of the non-US economy on the US dollar index. There are two reasons why the US dollar index is so strong: 1. The Federal Reserve's interest rate hikes; 2. The weakness of the non-US economy. The second mechanism is not as straightforward: there are two types of economic factors that cause an increase in the supply of US dollars in the US currency market. One is when the US economy weakens, which leads to an increase in the supply of dollars. The other is when the non-US economy strengthens, which displaces dollars. Specifically, if the economy of some non-US country is too weak, its economic system (imagine it as a sponge) will have reduced absorption capacity for its own currency, resulting in an increased demand for US dollars locally.
Except for China's struggling economy, other non-US economies, including Europe, are facing struggles due to the war between Russia and Ukraine and the energy crisis. Consequently, both the Chinese and Europeans are interested in holding US dollars, causing the US dollar index to soar.
In summary, there are at least three macro factors that determine the strength and weakness of Hong Kong stocks:
a. China's economy; (asset side)
b. US Federal Reserve monetary policy; (liability side)
c. Non-US economic conditions; (liability side)
The reason why the bear market in Hong Kong stocks can fall to such a tragic level is that the three factors are all working together [in 2022].
The special value of Hong Kong stocks to asset allocation is that: When the Chinese economy recovers, funds will move from “virtual to real” [Baiguan: This means that funds shift from speculative investments (such as stocks, derivatives, or virtual assets) to tangible assets and the real economy (such as real estate, infrastructure, or physical commodities]. As for A shares, its asset side is good [Baiguan: as China’s economy recovers], but its liability side is damaged [Baiguan: as funds flow into the real economy instead of the stock market]. If the effects of a recovering economy are stronger than the liability side, the entire A-share stock market would still rise.
However, Hong Kong stocks are valued based on US dollar liquidity. When the Chinese economy improves, US dollar liquidity will marginally improve [Baiguan: as China’s economic system increases demand for its own currency and therefore displaces dollars, resulting in more supply of dollars in the market]. Therefore, when the Chinese economy improves, the asset side and liability side of Hong Kong stocks both improve.
Viewpoints: Prospects of China's Economy
Regarding China's economic situation, recent data indicates a gloomy outlook. The Producer Price Index (PPI) has experienced a continuous decline for the ninth consecutive month, reaching -5.4% YoY in June. Additionally, the Consumer Price Index (CPI) recorded a 0% YoY growth in June, down from 0.2% in May, indicating an increasing concern about deflation. On the other hand, both New Yuan Loans (3.05 trillion yuan) and Total Social Financing (4.22 trillion yuan) surpassed expectations in June. However, the year-on-year growth of Total Social Financing decreased from 9.5% in May to 9%.
Now that we understand the key factors influencing the valuation, let's shift our focus to the asset side and explore various viewpoints from influential finance and investment blogs, economists, and financial analysts regarding China's economic outlook.
On stock market outlook
China International Capital Corporation (CICC) [source]:
July is a key policy window period for the Chinese and American markets and will have a decisive impact on future market trends. Due to the slow decline of the US core CPI affected by the low base, and the low possibility of China launching a new round of large-scale stimulus policies, the Chinese and American markets in July may maintain a volatile trend. We believe that the market will maintain a volatile trend at least in the foreseeable future. However, the rapid pullback in the US bond market and the Hong Kong stock market is not entirely negative. We believe that in the current situation where downside protection is relatively sufficient, the risk-return of the market is somewhat attractive. Our key arguments are:
We believe that the core CPI in the United States may decline rapidly in the third quarter, so the current 10-year US Treasury bond interest rate is relatively high, but investors still need to be patient and wait until the CPI data is released in mid-July;
The Hang Seng Index is approaching the 18,000-point mark again, and the overall price-to-book ratio has fallen below 1, with short-selling transactions accounting for a record high of 27% on July 5th.
Premier Li Keqiang presided over an Expert Symposium on Economic Situation on July 6th, proposing to timely introduce and implement a group of policy measures with strong pertinence, combination, and synergy. We believe that compared to simply implementing monetary easing or other support measures, it is more important to implement effective policies (fiscal or real estate) that are expected to expand credit. The Central Political Bureau meeting to be held at the end of July may play a certain catalytic role.
Hu Xijin, Journalist and prominent China influencer: “As a whole, stock investors and the stock market should have a greater impact on national economic policies” [source]
Some people criticize me for not buying stocks, but for attracting social media traffic. To be honest, I didn't expect that buying stocks could bring extra traffic to me. I do have additional motivations, but that is to gain a deeper understanding of the Chinese economy and society by experiencing the joys and sorrows of stock investors firsthand. I believe that the weight of the stock market in the Chinese economy will only continue to increase.
On review for China's 2023 H1 economic recovery
A “K-shaped” recovery: The China Finance 40 Forum, a top Chinese think tank on issues of economic and financial policy [source]
Net exports and domestic demand showed a K-shape: net exports continued to significantly exceed the trend level, while domestic demand remained weak.
High-end consumption and ordinary consumption showed a K-shape: the former recovered more strongly, while the latter had limited recovery.
Infrastructure investment supported by public funds and private investment showed a K-shape.
Real estate sales and construction, as well as regional differences, showed a K-shape. Sales have rebounded, but investment and new construction are still declining; except for first-tier cities, real estate sales and development are in a downward trend.
The destination of exports showed a K-shape: exports to Southeast Asia grew strongly, while exports to developed economies such as the United States, Europe, and Japan declined.
Overall, the economic recovery in China in 2023 has different situations for different groups, industries, and regions, which is of great significance for macroeconomic situation assessment and macro policies. If the focus of future policies can be on the lower half of K, then we can perhaps expect that the K-shaped recovery in the future may turn into a V-shaped recovery.
On China’s economic outlook and stimulus
Chinese Premier Li Qiang presided over an expert symposium on the economic situation. The experts reached a consensus on China's slower-than-expected recovery, calling for policy support. However, specific policy recommendations varied among the experts.
Liu Shangxi, head of the Chinese Academy of Fiscal Sciences under the Ministry of Finance:
It is a consensus among everyone that the recovery is below expectations…Based on some economic indicators, there have been signs of economic downturn starting from the second quarter of this year, which is April. This indicates that risks may be spreading and expanding, and there is little disagreement regarding this assessment. Implementing an active fiscal policy and a prudent monetary policy is clear. However, the adequacy of their intensity and effectiveness is another issue.
There has also been consensus regarding the need to strengthen debt management:
Liu Shangxi: “Currently, there is actually a way to address the situation, mainly by relying on increased leverage at the central level. Moreover, there is room for the central government to increase leverage because the proportion of national debt to GDP is not high. Currently, the scale of local government debt has exceeded that of the central government, and the effectiveness of relying on local macroeconomic control is declining while the risks are increasing. Therefore, it is necessary to realign and return decision-making and execution of macroeconomic control completely to the central government.”
Luo Zhiheng, chief economist at Yuekai Securities: “…continue to increase fiscal transfers from the central government to local governments, from provinces to cities and counties, to alleviate the fiscal imbalance and liquidity payment risks.”
For a detailed overview of the viewpoints of experts who attended the Expert Symposium on Economic Situation held on July 6th in China, we highly recommend reading this post by Pekingnology:
Cai Fang: “What is needed now is to stimulate household consumption, and household registration reform can release 2 trillion yuan in consumption by migrant workers” [source]
At the 9th "China Fortune Forum" held on July 8th, Cai Fang, a member of the Standing Committee of the Thirteenth National People's Congress, former vice president of the Chinese Academy of Social Sciences, chief expert of the National High-end Think Tank of the Chinese Academy of Social Sciences, and a member of the Monetary Policy Committee of the People's Bank of China, stated that:
“…household consumption behavior determines the direction of consumption and savings, and also determines the impact and guidance on the real economy. Currently, China's economy is facing a new normal from the demand side, and demand-side factors, especially consumption, have become important factors affecting the economy. Judging from the current income level of migrant workers, due to concerns about public services and social security, their consumption capacity has been suppressed by about 23%. Through household registration reform, the consumption willingness of the migrant worker group can be effectively released, and "the total amount can be as high as trillions."
On exchange rate
China Financial Times: Rationally dealing with RMB exchange rate fluctuations [source]
According to industry experts, China's foreign exchange market will remain stable, and the Yuan exchange rate will gradually stabilize.
Wu Dan, a researcher at the China Banking Research Institute: In the next stage, with the weakening of spillover effects, cross-border capital flows are expected to become more stable, and the RMB exchange rate is expected to stabilize and rebound. In particular, foreign investors have recently increased their allocation of fixed-income assets such as bonds in China's domestic market, attracting foreign capital to continue to flow back.
Ming Ming, China International Capital Corporation's Chief Economist: “In the medium to long term, the US dollar index may weaken as the US economy gradually comes under pressure and the Federal Reserve's tightening policy approaches its end. At the same time, China is expected to launch a "combination punch" policy that will drive economic fundamentals to bottom out and rebound. This will support the RMB exchange rate, stabilizing it and possibly even returning it to an appreciation trend.”
*Financial Times (China) is supervised by the People's Bank of China and is designated as an important information disclosure media by the People's Bank of China, the China Banking and Insurance Regulatory Commission, and the State Administration of Foreign Exchange, as well as a securities market information disclosure media.
With China cutting benchmark rates and the US Fed remaining ambiguous on the possibility of keeping rates higher for longer, the market is trading on the expectation of a continuing widening of the US-China yield gap. This is not helpful news for the valuation of Hong Kong shares. In addition to this, China's worrisome economic data has caused market sentiments to diverge between overseas and onshore investors. (According to data from EPFR, last week overseas active funds again flowed out of overseas Chinese-funded stock markets, with an outflow scale of USD 231 million. At the same time, mainland Chinese investors increased their holdings of Hong Kong stocks through the Hong Kong Stock Connect by a total of HKD 6.71 billion last week. [source])
Could this be the lowest point of market sentiment?
One observation is that China is committed to boosting its economy, stabilizing the exchange rate, and encouraging private investment. This marks a drastic shift in focus compared to 2022. There is a consensus that the pace of recovery is below expectations, and many are calling for more policy support in the near future. While the specific implementation measures vary among experts and economists, common themes revolve around fiscal policies, debt management, and boosting domestic consumption. As pessimistic sentiments persist, it is worthwhile to closely monitor how policies support domestic recovery. The recovery economy, coupled with the end of the US's current hiking cycle, could also bring attractive returns.
Next week, we will release a "Charts of the Week" series post recapping China's Q2 data. This post will cover key data points, including domestic consumption, real estate, consumer sentiments, employment outlook, and more. Subscribe to stay tuned!